# Patents versus Markets

on March 16, 2009 at 7:31 am

Long ago Jack Hirshleifer pointed out that markets can reward innovative activity even in the absence of patents (H.'s point was actually that markets could over-reward such activity but the point was clear).  If an inventor discovers a new source of energy that requires the use of palladium, for example, he can buy palladium futures, announce his discovery and wait for the price of palladium to increase.  Of course, this only works if the discovery is credible so betting (contra Tyler) is an important way to test the credibility of a theory (e.g. here and here and of course Hanson's key paper Could Gambling Save Science).

All this is by way of introduction to a new paper in Science, Promoting Intellectual Discovery: Patents Versus Markets (press release here).  Bossaerts et al. compare a patent system with a market reward system in an interesting experimental setting.  The innovation is the solution to a combinatorial problem called the knapsack problem.  In the knapsack problem there are Z items each with a certain value.  You must choose which items to put into the knapsack in order to maximize it's value but each item also has a weight and you cannot go over a fixed weight which is set such that you can't carry all the items.  The solution to a knapsack problem is not obvious since it's not always best to include the most valuable items.  The authors argue that solving the knapsack problem is like combining ideas to create a new innovation.  The authors, of course, know the optimal solution to each knapsack problem.

Rewards for creating the innovation are offered in two ways, in the patent method the first person to produce the optimal solution gets the entire reward.  In the market system each participant is initially given an equal number of shares in each item.  The item-shares trade on a market. After the markets close a \$1 dividend is paid to each item-share if the item is in the optimal solution, other shares expire worthless.  Thus, the price of the item-shares can be thought of as the probability that the item is in the optimal solution.  (i.e. is palladium in the optimal solution to the energy problem?  If so, it will have a high price.)  Dividends are set such that the total reward is about the same in the two treatments.  Proposed solutions were also collected in the market setting although the solutions per se were not the basis of any reward.

Important findings are that the problem was solved just as often in the market setting as in the patent setting.  Indeed, in the market setting more people solved the problem on average.  There are two possible explanations.  First, the winner-take-all nature of the patent system may have deterred some of the weaker participants from exerting effort.  Second, and more interesting, is that the prices in the market system did in fact incorporate information about the optimal solution – thus market prices may have given people hints about the optimal solution, much like seeing a partial solution to a jigsaw puzzle.

Problems are that the market system can work only if there are rents to be had from market prices.  A new computer chip design, for example, won't change the price of silicon (although even here side-bets may be possible, the inventor knows the manufacturer to whom he sells the invention for example).  Also, the price of an input, like palladium, can be influenced by many things other than the innovation so the market system will typically often involve more risk.  Still this is an interesting experimental approach to a deep problem.

Thanks to Monique van Hoek for the pointer.

1 Mark Gray March 16, 2009 at 9:00 am

Discussions about intellectual propert rights are always interesting. I was wondering if Marginal Revolution might address the proposed EU directive for copyright term extension for recorded music. It’s been gathering a lot of attention since the European parliament is set to vote about it on March 23.

2 Zamfir March 16, 2009 at 9:15 am

Interesting. Perhaps the patents vs markets tag doesn’t really apply? This mechanism would work with and without patents, and we would expect to see it even in an environment with patent rights. Are there significant historical examples?

I can imagine that reliability is an issue, i.e. when trying to get funds for innovation, you can’t work on the premise that your eventual discovery will definitely allow this mechanism. And if after the discovery you find that you can use this mechanism to get rewards, than that’s a nice bonus, but it doesn’t spur innovation a priori.

3 Mathieu P. March 16, 2009 at 10:38 am

I fear that this article misses the whole point of patents (no big deal, since Bessen and Maskin’s “Sequential Innovation, Patents and Imitation” also missed it) is to *reduce* the rents accruing to an innovator.

When you file a patent, you get a rent in exchange of publicizing your discovery (enabling other people to use some of the ideas or to build cumulative innovation over it). Without a patent system, you are better off by keeping the workings of your discovery secret (like Coca Cola’s exact formula), barring other people from incremental discovery. The whole idea of patents is not to ensure proper incitations for innovation, but incitations to publish innovative processes.

The experiment is nice, but answers the wrong question, I’m afraid.

4 blabla March 16, 2009 at 11:00 am

Wouldn’t the insider trading rules need to be amended to let this work in real life? For example, I think that if you were to buy the stock of a corporate partner based on the information that the partner’s revenues are about to increase from a jointly-produced technology, that might qualify as insider trading. Not 100% sure though.

5 Michael F. Martin March 16, 2009 at 11:31 am

“Problems are that the market system can work only if there are rents to be had from market prices.”

Not an insignificant problem for inventors who don’t know how to analyze financial statements or otherwise value securities, options, or derivatives. Moreover, even if they could deconvoluting out the impact of a new invention on the valuation of a security or derivative is not something that even a professional would be able to do consistently!

6 Zamfir March 16, 2009 at 11:38 am

although even here side-bets may be possible, the inventor knows the manufacturer to whom he sells the invention for example

But in that case the selling itself seems a much stronger mechanism. If the buying company profits enough from that sale to have effect on its stock, you should have asked more in the first place. And you can otherwise only capture most amount if you buy options for the entire stock of the company, which seems a bit excessive

7 odograph March 16, 2009 at 11:43 am

Well, I’ll give you the “coke must have never patented” thing. I’ll say I was still waking up. On the second, explain the MS EULAs to me, and how there are a boon to individual rights.

8 anon March 16, 2009 at 12:17 pm

Non sequitur, odograph.

What does MS’s EULA have to do with a small inventor’s right to invent? Microsoft may have onerous license agreements. I don’t read them because I find that they don’t prevent me from performing my daily tasks. I just click “ok† and get on with my life – it isn’t worth my time to read a bunch of stuff that doesn’t apply to me. “Onerous† is in the eye of the beholder.

You can choose to not buy their products and therefore won’t be subject to their agreement. No effect on individual rights unless the individual voluntarily consents in exchange for the right to use their product.

As far as patents go…just what are the patent-related restrictions Microsoft places in their EULA’s? How are they onerous to small inventors?

BTW, Microsoft has thousands of patents. Each one cost them thousands of dollars. Every patent owned by someone else is a financial risk. Small independent inventors with good, valid patents are the biggest risk because they can’t offer a cross license–they have to pay. Microsoft simply wants to be rid of the known and potential costs of the patent system as it isn’t necessary to their business model — which ensures domination via the network effect.

Now big pharma, on the other hand….

9 anon March 16, 2009 at 12:30 pm

Tfvi,

I think that depends strongly on the technology.

But you are correct, it is very difficult to get capital without showing investors that your super-cool technology is at least nominally protected.

10 anon March 16, 2009 at 2:02 pm

Depends on the purpose. A patentability search in many techs is under \$1,000, in electronic areas can go up to a couple grand. A freedom to operate search is generally harder and a bit more expensive.

OTOH, you can file a patent application with the PTO claiming your invention and get a “free” search and maybe even a patent out of the deal. (“free” as in you can’t opt out of it — it is the same price whether or not you search on your own before filing).

11 Glen March 16, 2009 at 5:12 pm

“Important findings are that the problem was solved just as often in the market setting as in the patent setting. Indeed, in the market setting more people solved the problem on average.”

This is not an argument in favor the market. Between two systems that produce about the same level of innovation (that is, solving the problem equally often), we should prefer the one that does so with less effort. If more people solve the problem in the market system, that’s wasted effort. Some of the problem-solvers’ time could have been devoted to other things.

12 R C Dean March 16, 2009 at 9:41 pm

Patents, copyrights, and other forms of intellectual property form the foundation for their own markets. You can’t have a market unless you have a property right of some kind to sell. Patents and copyrights merely define the salable property rights in intangible property. I find the whole “patents v. markets” formulation to be a kind of category error. The real question(s) should be:

(1) Do we want to have intellectual property rights?

(2) If so, what form should they take?

The market in such rights (or the other kinds of value created by innovation) will take care of itself.

Basically, the no-intellectual-property position rests on the assumption that having enforceable intellectual property rights causes a net loss of global value and/or that such rights provide less incentive to innovate than the absence of such rights. The thought experiment above does little to illuminate these issues, as far as I can tell.

13 allison March 16, 2009 at 10:42 pm

(cont)

It seems to be that patents work well precisely when the solutions aren’t easily verified. Patents don’t work well otherwise, because your disclosure of how they work levels the playing field for all future innovation in the same direction, since the tiniest of variations will be outside your patent, and your only current advantage only comes from the willingness to litigate to protect your solution. But if verification that the patent worked is in and of itself terribly expensive, then others on disclosure will not necessarily invest to move the ball farther down that line of inquiry.

This gets back to the difference between pharma and software.

14 Mathieu P. March 17, 2009 at 5:38 am

odograph: I indeed was groping for “Trade Secret”, but the English term slipped out of my mind.

As a response, the problem with the current patent system is less a confiscation by a corporation of any kind as a problem of incentives (reference: http://faculty.lebow.drexel.edu/duchenea/Research/research.htm ). Broadly speaking, patent offices get money whenever they accept a patent, sound or not, and pay nothing if a patent is ruled inusfficient by a court. Hence, they have a clear incentive to accept poorly drafted, insufficiently innovative or documented applications, and no incentive whatsoever to reject outright lousy ones. I think this idea may interest Alex or Tyler, sonce it is a clear example of poor mechanism design with seemingly huge but overlooked consequences.

As for other comment, the profit opportunity gives no incentive to publish either. The innovator could have interested people sign a NDA, and operate under trade secret with his partner afterwards.

15 Ben March 18, 2009 at 8:04 pm

This is fantastic ~ I participated in this experiment as a subject while at Caltech, but they never tell you what the purpose of the experiment is; I’ve been wondering for a long time. Incidentally, I made a below-average amount of money in the market games and a killing on being the first to solve one of the winner-take-all problems…I wonder if this means I should question my libertarian views 🙂

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